Higher rates are coming — here’s how you prepare

Opinion: First of all, don’t panic because there are ways to protect your money

Momentum stocks — from social-media giant Twitter
TWTR, +0.12%
to electric-vehicle maker Tesla
TSLA, +0.15%
to biotech firm Celgene
CELG, +1.43%
— have run into serious trouble. As a result, investors have piled into low-risk trades again, and strong demand for Treasuries has pushed down yields steadily this year.

After peaking above 3% around New Year’s Day, yields on the 10-year Treasury bond are around 2.6% currently.

Some investors may not think that a change of 40 basis points is a big deal. But consider that while rates have drifted down, bond investments like the iShares Barclays 20+ Year Treasury Bond ETF
TLT, +0.22%
have marched higher. This fund, which as the name implies owns long-term Treasuries, has added 10% in value since Jan. 1 while the broader market is flat.

That’s how bonds work; when yields drop, bond prices rise.

But it’s important to remember the flip side of that trade — when yields rise, bond values decline. For instance, the TLT fund lost a substantial 17% in value from May through December of 2013 as interest rates on the 10-year Treasury bond almost doubled, from a low of about 1.6% in the spring to 3% after Christmas.

Long story short: If you own any kind of bonds or bond funds, as any diversified investor should, you will be seriously affected by even a modest rise in interest rates.

And make no mistake, they will rise soon.

Here’s why you should expect interest rates to move higher — and, most importantly, what to do to keep your money safe.

Why yields will rise in 2014

A choppy market has driven investors back into safe-haven investments. But the short-term volatility can’t overshadow a powerful one-two punch that will lift interest rates over the next year: the steady healing of the U.S. economy, and the tightening of monetary policies at the Federal Reserve as the recovery builds.

But rather than read the ramblings of a financial pundit, instead consider the fact that the Fed just tapered its bond-buying purchases by $10 billion again in April. Quantitative-easing efforts are now running at roughly half of what they were in December.

Here’s the reason for the continued taper, in the Fed’s own (near-incomprehensible) wording:

“In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases.”

Naysayers insist that the economy (and stocks) will tank without QE. And skeptics will also point out that the end of QE does not at all guarantee a rise in the federal funds rate, since Fed Chairwoman Janet Yellen has taken pains to state rates will stay low for some time.

But Fed haters have been doubting the recovery for over five years now, so forgive me if I don’t start listening in 2014. And while it’s true the fed funds rate may not itself budge, that doesn’t mean rates are fixed.

After all, the surge in rates on the 10-year note from 1.6% to 3% from May to December 2013 took place with no change to the key interest rate level set by the Federal Reserve.

If you want to bet the U.S. economy is going to implode in spite of a 6.3% unemployment rate that is the lowest since late 2008, be my guest. And if you believe the only reason for a 175% rally in stocks since the March 2009 lows was solely because of QE and that the end of bond buying will cause a crash, go ahead and take the other side of the trade.

But every day we move further away from the Great Recession without a disaster means investors, consumers and businesses get more confident.

That means a stronger economy and a higher risk appetite, which, in turn, add up to higher rates.

Protect your portfolio with these moves

If you believe rates will rise — maybe not immediately but in the next year or so — how do you prepare?

The asset class that will be most affected by a rise in rates is, obviously, bonds. And the biggest thing people hear is that when rates rise, the value of bonds goes down.

But selling all bonds and bond funds just to avoid any risk to your principle is a foolish thing to do, particularly if you are in retirement and depend on the income from your investments.

The right approach, then, depends on your specific investing goals and how you plan on diversifying to avoid interest-rate risk; It’s a balancing act, make no mistake, and there are no “right” answers.

Still, here are some specific tips that may help you balance the need for diversification and income with the concern of higher rates weighing down your bond investments:

Consider holding some bonds to maturity: The face value of a bond only matters if you sell it, so if you hold a bond to maturity, there is no risk of loss. If you’re content with your coupon payments, then simply keep collecting them and forget about what market pricing is on a day-to-day basis. The risk is that, if inflation rises dramatically, a bond with a 2.5% yield may barely be treading water in a few years. But considering inflation is running at a 1.5% rate and hasn’t topped 3% since 2011, that doesn’t seem to be an immediate concern.

Consider paring back on long-term bond funds: Many investors don’t have the capital to buy a variety of bonds or don’t feel comfortable doing the research on individual bonds. So they rely on bond funds, which are a great way to own a basket of corporate and government debt, spreading around risk. The problem in an environment where rates rise is that most turn over their holdings by selling bonds on the open market, leaving you open to principle declines. The diversification and ease of investing is nice, so I’d never advocate bailing on all bond funds. But understand the trade-off you are making and the risk of losses in principle if rates rise.

Consider short-term bond funds: Many investors think short-term bond funds are batty, since in this low-interest-rate environment they can yield less than 1% in income. What’s the point of such a meager yield? Well, the point is capital preservation and protection from interest-rate risk. As a working example, compare the deep 17% declines in the TLT long-term bond ETF from May to December last year vs. a negligible 0.1% decline in its sister fund, the iShares 1-3 Year Treasury Bond ETF
SHY, +0.00%
across the same period. Shorter-yield bonds offer lower yields, but have much less interest-rate risk. Again, it’s a trade-off if you need income, but it’s another tool in your tool box.

Don’t forget bond-like stocks: Of course, all this reference to bonds ignores the fact that some of the best-yielding investments out there are actually stocks. And, in fact, “bond-like” equities including utility stocks, blue-chip telecoms, REITs and other stable dividend payers have been going gangbusters in 2014 as investors go “risk off.” Again, the balancing act between risk and reward is crucial here, and you should never dump all your money into stocks because if we see a steep 15% or 20% correction in the market, that could be much worse than any hit you would have taken in your bond funds. But in a diversified portfolio, low-risk income stocks have a very important role to play. And it just so happened I gave you three stable picks for a rocky summer in my column last week.

Stay disciplined: The best portfolios are not set in stone and adapt to your personal investing needs and the market environment. However, there are some things that never change: a low-risk portfolio is always diversified, and that any investor who panics based on the whims of the market will do more harm than good. While I think the very real possibility of higher rates in the second half of 2014 holds some short-term challenges, particularly for bond investors, the most important thing you can do is keep your eye on your long-term investing goals.

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